BEWARE of Bonds!

Kathy Fettke

Kathy Fettke

Investors often buy bonds because they think they are safe. In reality, they are much riskier than you might think.

Slowed economic growth globally, resulting in negative interest rates abroad, are driving international investors to the safety of U.S. Treasuries.

This flight to safety has worked since treasury bonds and gold have outperformed stock market investments so far this year.

But some prominent Wall Street folks have raised concerns about how safe Treasuries really are.

JPMorgan Chase CEO Jamie Dimon shared his concern in his annual shareholder letter last year that there are fewer bonds readily available in the market than there were in 2007. This means fewer people are re-selling.

He wrote, “In a crisis, everyone rushes into Treasuries to protect themselves. This will be even more true in the next crisis. But it seems to us that there is a greatly reduced supply of Treasuries to go around.”

High demand and low supply drives prices up, creating roller coaster ups and downs during a short period of time. Volatility like that is not what most investors are looking for when they buy bonds. They are looking for safety and stability.

In October of 2014, the bond market went on a wild ride – which was later dubbed as the Treasury flash crash.

Simon Potter, executive vice president of the New York Federal Reserve, blamed that day on the development of automated trading and warned of the “possibility that sharp intraday price moves become more common.”

If the Federal Reserve raises interest rates this year, it could pose further risk to the bond market. Interest rate hikes have happened once since 2006 – just this past December, many new investors are unfamiliar with what happens to bond trading during a Fed rate hike. And those who are familiar with what happens historically aren’t able to predict as well as they used to.

Usually, investors sell bonds, and yields go up when the Fed raises rates. But the opposite happened this December. Bond yields actually decreased and have remained relatively low.

U.S. Treasury bonds are considered a “safe haven,” because investors have the full faith of the U.S. government to back the investment. But is government always so trustworthy a borrower?

Not for those who bought Puerto Rican bonds. Those investors may not see a penny back from their bond purchases, even though Puerto Rico’s constitution guarantees that bond payments must be made before all other payments.

How can they get away with this?

Here’s how: According to a report from the newly formed Public Credit Comprehensive Audit Commission, issuance of these bonds violated Puerto Rico’s debt ceiling.

Yet, the offering statement for these bonds promised the opposite. It clearly illustrated that Puerto Rico would remain under its legal debt ceiling, even after issuing this round of bonds. There’s even a section where legal counsel states these bonds are duly issued and fit the parameters established by Melba Acosta-Febo, Secretary of the Treasury for the island at the time.

The offering statement did explain that Puerto Rico faced severe financial risks and that investors should proceed with caution. However, with higher risk comes higher reward, right?

As such, investors gobbled up $3.5 billion in bonds, issued in 2014, believing they would be paid back before all other commitments.

But now, Acosta-Febo and Puerto Rico Governor, Alejandro Garcia Padilla, seem to be ignoring this legal contract, claiming instead that all $3.5 billion dollars worth of bonds were issued illegally.

The governor has already stated he will not pay bondholders ahead of salaries and pensions, even though his constitution explicitly requires it.

This sounds like outright deception and fraud (yet with no government official facing an indictment). Innocent people bought those bonds based on promises made in the offering documents – promises made by the Secretary of State.

You may wonder if maybe Acosta-Feb just made a mistake when creating the offering documents because she didn’t know the actual debt ceiling of Puerto Rico. That’s not possible. Acosta-Febo is an accountant, a lawyer and has an MBA from Harvard. She’s no dummy.

When these Puerto Rico bonds were issued in 2014, Rodney Johnson, senior editor of Economy & Markets, told readers to stay away. At the time, he thought the island was broke and would default. Default implies the government was trying to make good. Instead, they resorted to outright theft.

Some bond holders may think that kind of corruption couldn’t happen here in the mainland USA.

Unfortunately, that’s not true. Puerto Rico actually followed the footsteps of the city of Detroit, who did the exact same thing 3 years ago and got away with it. Detroit also tried to bail itself out of it’s financial mess by selling $1.5 billion in bonds. Later, city officials claimed the bonds were illegally sold and that bondholders had no claim.

WOW.

Keep an eye on other U.S. cities who can’t pay their bills due to extravagant government spending (Chicago). Whatever you do, don’t buy their bonds! They are NOT safe. You can watch on the sidelines as more and more investors snap up municipal bonds for yield and safety.

Instead, you can choose an investment that no one can lie or steal from you. AND you can get much higher yields and greater safety than bonds.

Do you think that if you bought property in Puerto Rico, the government could take that away from you? I have a close friend who owns property in Puerto Rico. Values have continued to rise, in addition to rents. What if you bought a rental home in Detroit 3 years ago when the city was issuing bonds? The yield on your rental income would be closer to 14% and home values would have actually increased substantially since then.
If you don’t want to be a landlord, consider private money lending, where your funds are secured in 1st lien position to a property. No one can say the documents weren’t accurate and that you don’t own that property.

Kathy Fettke